<i>Slate</i> Writer Is Dead Wrong to Root Against Community Banks

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WASHINGTON – Slate's economic and business blogger, Matthew Yglesias, published a provocative blog post on Tuesday, essentially arguing that community banks need to be euthanized.

No fan of the biggest banks either, he called for a system that limits the megabanks while encouraging the regional players, like U.S. Bancorp (USB), PNC Financial Services Group (PNC) and Fifth Third Bancorp (FITB), to "swallow up local franchises and expand their geographical footprints." Instead of the 6,891 banks that existed at the end of the third quarter, Yglesias envisions a world in which "dozens rather than thousands of banks exist."

To support his vision, Yglesias posits three arguments: Small banks "are poorly managed"; they "can't be regulated"; and they "can't compete."

Yet he provides scant evidence to back those claims and an examination of the current environment facing small banks suggests that in all three cases he is dead wrong.

Here's why:

1. Most Small Banks Are Well Managed (And Aren't Dumb)

Among the more inflammatory remarks in Yglesias' blog post is the suggestion that community bankers are simply stupid. In his words: "You know how the best and brightest of Wall Street royally screw up sometimes? This doesn't get better when you drill down to the less-bright and not-as-good guys. It gets worse."

I'm not sure why Yglesias assumes small banks are populated by Wall Street-rejects who couldn't hack it in the big city, but that simply isn't the case. Most small banks are run by individuals who have risen locally through the ranks or were poached from nearby institutions.

Unfortunately, there are no good statistics to refute his sweeping claim. Generally speaking, however, it's fair to use the Camels rating system, which includes "management" as part of its criteria. (For non-bankers: Camels is a confidential grading system for banks, with the best score being 1 and the worst being 5.)

As of Sept. 30, there were 515 institutions on the Federal Deposit Insurance Corp.'s "problem bank" list, the vast majority of which are Camels 4- and 5-rated banks. While all of those are almost certainly community banks, they make up just a sliver (7.4%) of the overall number of institutions.

Those looking for more proof should consider this: The vast majority of community banks survived the financial crisis, an unprecedented period of turmoil that challenged and nearly defeated many of the so-called "best and brightest." That is a pretty big indication community banks have talented people at their helm.

2. Small Banks Are Way Easier to Regulate

The most perplexing argument that Yglesias makes is that small banks "can't be regulated." He goes on to say that "small banks regularly get various kind of carve-outs from regulation" because policymakers want to ensure their survival.

It is true that small banks receive periodic exemptions from some regulations. For example, institutions with less than $10 billion of assets are not examined by the Consumer Financial Protection Bureau. The Federal Reserve Board's cap on interchange fees for debit cards also does not apply to small banks.

Yet the vast majority of rules and regulations do, in fact, apply to small banks. While the CFPB carve-out exempts small banks from oversight by that agency, they still have to follow the rules it writes. The Fed interchange cap, too, could end up affecting small banks after all, if retailers pressure them to match the lower rates bigger institutions charge.

Moreover, some of the biggest new rules required by Dodd-Frank also apply to small banks. Take Basel III, a collection of new capital and liquidity rules that most everyone thought should apply only to the largest banks. Instead, regulators have applied it to all institutions with limited exemptions. The other big rules of Dodd-Frank, including sweeping new mortgage and underwriting regulations, mostly apply equally to all banks, regardless of size.

Leaving aside which rules apply to whom, the bottom line is that the small banks are regulated by a horde of examiners from state and federal agencies. The vast majority of institutions are examined each and every year. The FDIC, which oversees most small banks, has roughly 3,000 people dedicated to bank supervision, according to its latest budget. That figure does not include the thousands of state examiners, with whom the FDIC shares oversight of nonmember state-chartered banks. It's hard to think of an industry that is more regulated than banking.

Moreover, let's not forget that it's far easier for regulators to oversee small banks, which by and large engage in the traditional business of banking: Taking deposits and making loans in their communities. Compared to a megabank (whose far-flung operations may include, ahem, derivatives traders in London) or even a regional institution, it is much simpler for regulators, not to mention the general public, to look at a small bank's business and assess its health.

3. Small Banks Are Profitable and Competitive

Yglesias concludes that if "you want the JPMorgan Chases and Bank of Americas of the world to be held to account, you need both regulation and competition. But a bank serving a handful of rural counties or a single midsized city doesn't offer any real competition."

Whether or not small banks are competitive depends a great deal on how you define "small." It is true that America's smallest institutions, those with less than $100 million of assets, are struggling. Those institutions – there are 2,117 of them at last count – generate a return on equity of 6.16%. That's significantly below the industry average of 8.92%, as well as institutions above $10 billion of assets (8.87%), according to the latest FDIC data.

Banks with $100 million to $1 billion of assets – the bulk of the industry's numbers, at 4,106 institutions – are more competitive. Their return on equity is 8.51%, close to the industry average and not far behind their biggest brethren.

For institutions with $1 billion to $10 billion of assets, a universe of 561 banks that are still considered community institutions under every known definition, the future is even brighter. Their ROE is 9.9%, well above the other peer groups – proof, if needed, just how competitive small banks can be.

Moreover, there are legions of stories about small banks that continue to thrive even in the current environment, including Monarch Bank and Cardinal Bank in Virginia, German American Bancorp. in Indiana and Eagle Bank in Maryland. American Banker Magazine recently compiled a list of the best-performing small banks with less than $2 billion of assets, ranked by average return on equity over the past three years. Of the top 20 banks listed, 15 had less than $1 billion of assets.

But Yglesias didn't discriminate by asset size, appearing to lump in all banks below regional status as "microbanks." Had he limited his remarks on competitiveness to the smallest institutions, he might have had a point in saying that policymakers need to take a hard look at their viability.

Yet even if policymakers decided to kill off the smallest, weakest-performing institutions, that would leave nearly 4,700 banks – an order-of-magnitude larger population of banks than the "dozens" envisioned by the Slate blogger.

4. Small Banks Are Vital to Credit Availability

Accepting Yglesias' premise could prove disastrous. Forming an oligopoly of regional banks is bound to leave fairly big coverage gaps. Scores of markets, especially across rural America, would be underserved at the onset of such a shift. Bank of America (BAC), for instance, has one of the nation's largest branch networks, but management blatantly skipped Mississippi while they expanded. There are plenty of people in Mississippi – not to mention large swaths of Kansas, Nebraska and Wyoming – who need loans and other bank services.

It's also not clear who would lend to the nation's smallest businesses, many of which lack the proper documentation or size to catch the eye of larger lenders. Data provided at the Federal Reserve's inaugural conference on community banking, held in October in St. Louis, found that community banks are best equipped to handle so-called "opaque information" when looking at a loan application. In many instances, the loan is based more on the bankers' understanding of the market, the borrower and the situation -- and smaller banks tend to do an exceptional job in this arena.

Looking ahead, it appears certain that there will be fewer banks in this country. Given the regulatory and economic headwinds small institutions face, it is not surprising that many are selling to credit unions, other community institutions or regional and large banks. Some experts have predicted that the downsizing will leave the country with around 5,000 banks.

Yet it seems bizarre to actively root for such an outcome. There's a reason most Americans like their local banks, even if they detest the megabanks after the financial crisis. Small banks are better positioned to understand their customers' needs and as a result, usually provide better service. Their existence is uniquely American, and while they have made plenty of mistakes, they pale in comparison to those made by their larger brethren. If you are worried about the safety of the economy, you want more small banks, not fewer. They pose less systemic risk and their failures are uneventful.

Small banks' alleged demise is something to resist, not cheer on.

Rob Blackwell is the Washington bureau chief of American Banker. The views expressed are his own. Paul Davis and Alan Kline contributed to this post.

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